WASHINGTON (MNI) – The following is the second part of the full
text of the speech by Richmond Federal Reserve President Jeffrey Lacker
Wednesday, giving an early assessment of the regulatory response to the
financial crisis:
The involvement of Fannie Mae and Freddie Mac in housing finance
set them up for a central role in the financial crisis. Their hybrid
mission of supporting social home-ownership goals and providing returns
to their shareholders, when combined with the perception that their debt
was government-backed, made it almost inevitable that they would
over-leverage. Estimates of their purchases and guarantees of high-risk
mortgages from 2002 to 2007 range from a third to a half of total
high-risk issuance.
The role of large U.S. banks in the run-up to the crisis was a bit
more indirect, but potentially consequential nonetheless. Most subprime
and Alt-A mortgages were originated outside of the commercial banking
system, but the process through which mortgage risks were
re-intermediated involved banks in several key steps. Many of these
mortgages found their way into off-balance sheet entities that issued
asset-backed securities, including commercial paper. These arrangements
often benefited from explicit backstop liquidity agreements provided by
large banks, or the backstop commitment implied by the reputational
concerns of their large bank sponsors. These credit enhancements put
banks on the hook in the event that investors lost confidence in the
underlying assets. This is exactly what happened, of course, causing
risky off-balance assets to boomerang back onto banks’ balance sheets.
But providing this kind of support to the securitization process simply
reflected large banks exploiting an artificial competitive advantage
they enjoyed. Because of the presumed government backing associated with
their too-big-to-fail status, they were better able to hold exposures to
large aggregate shocks – particularly those involving a scarcity of
liquidity – than other market participants. The implicit safety net for
large commercial banks thus encouraged them to provide credit
enhancements to the securitization process, which further boosted the
market for risky mortgage loans.
The U.S. housing GSEs, as I noted, were responsible for a
significant portion of the ultimate demand for risky mortgage-backed
securities. But European banks, many seen as too big to fail by their
home countries, also took on significant exposures to U.S. housing debt.
Thus a substantial amount of subprime and non-traditional mortgage debt
appears to have been held by financial institutions whose risk-taking
incentives were distorted by safety net support regimes. Future research
will be needed to quantify the extent to which such incentive effects
could, by themselves, account for the magnitude of the housing boom and
subsequent bust. Qualitatively, however, the moral hazard problems
infecting the ultimate investors in mortgage-backed securities could
plausibly explain seemingly suboptimal behavior throughout the housing
finance pipeline, from deceptive origination practices to manipulated
rating agency analyses.
Having been central to the build-up of risks, safety net ambiguity
also played an important role, I believe, in how the ensuing crisis
unfolded. In the initial bout of financial market turmoil in August
2007, investors pulled away from financial institutions that were
perceived to have significant potential exposure to subprime mortgage
losses, including through liquidity support for off-balance sheet
entities. Interbank borrowing costs rose as lenders demanded higher
counterparty risk premia. The Federal Reserve responded by lowering the
discount rate’s spread over the target federal funds rate and
encouraging visible use of the discount window to dispel the “stigma
effects” that were believed to discourage borrowing. This conveyed the
message that central bank lending would be forthcoming to prevent or
ameliorate the adverse consequences of the tumult in financial markets.
While many financial firms raised additional capital in the months that
followed, some institutions, including Bear Stearns and Lehman Brothers,
let opportunities to improve their balance sheets and reduce their
vulnerability to a loss in investor confidence pass them by.
Uncertainty about whether the short-term creditors of such firms
would be protected by government support meant that policymakers faced
an excruciating dilemma if one of them ran out of liquidity. Letting a
firm file for bankruptcy could diminish the odds investors placed on
government support for other similarly-situated firms, risking a sudden
investor retreat that would add to market volatility. Protecting
creditors and counterparties becomes irresistible, despite knowing how
it might exacerbate moral hazard. By late September 2008, the fact that
six large financial failures had been handled five different ways
caused tremendous market uncertainty regarding the status of safety net
protection. At that point, establishing and articulating credible new
boundaries around future support would have been very difficult. This
suggests that future assessments of the official response to the
financial crisis will hinge less on the TARP and the large-scale market
interventions by the Fed that followed AIG, and more on how the sequence
of actions in the year before might have discouraged critical actions
that firms could have taken to protect against financial distress.
One result of the crisis is that official support has been given to
a set of firms and markets that extends well beyond our estimate of the
safety net as of 1999. Taking into account actions taken over the last
three years, Richmond Fed researchers have updated their safety net
estimate to the end of 2008, with the figure for implicit protection now
standing at 37 percent of financial sector liabilities, reflecting the
growth in the housing GSEs and the extension of support to financial
institutions beyond commercial banks. Interestingly, while the fraction
of financial sector liabilities backed by explicit government support
has declined to 22 percent, the total safety net has grown to cover 59
percent of the financial sector at the end of 2008. The expansion we’ve
seen in the safety net over time has been, I believe, a direct result of
the ambiguity of unstated, implicit guarantees.
-more- (2 of 3)
** Market News International Washington Bureau **
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